Rebuilding the American Dream: What's Really Holding Back U.S. Housing

Residential real estate in the United States was at the center of the economic meltdown we now call the “Great Recession.” Excessive borrowing fueled a massive housing boom that was followed by an implosion of real estate values and sales, shaking the public’s faith in an asset class that many people once considered the cornerstone of their asset portfolios. Five years after a one pillar of the “American dream” crumbled, what is the state of the housing and real estate markets?

Building starts for new homes tend to provide one of the most sensitive indicators of housing demand. The number of single-family housing starts reveal the stark reality of the recent boom and bust. Single-family starts ran at an annualized rate of about one million starts for many years, rose to a rate of almost 1.8 million starts at its peak during the middle of the last decade, and then collapsed at the bottom to a rate of slightly less than 400,000 starts. At this point, the number of single-family starts has risen back to an annual rate of 656,000. The good news is that housing starts have increased significantly off the bottom. The bad news is that the normal rate of starts prior to the housing boom was around one million annually, and we certainly have not returned to that level of construction.

Why have we made so little progress over the course of the last five years? First, we would note that the slow recovery in housing is consistent with what we often see when valuation “bubbles” drive the prices of financial assets up dramatically. As a general rule of thumb, after assets go through a massive boom and bust, it often can take ten years for markets to normalize. Strong underlying fundamental demand for an asset may shorten the recovery process, but the reality is that it often takes longer than we expect to eliminate the excesses created by asset bubbles.

Investment psychology is one reason that it takes so long to rebuild demand for an asset once a bubble bursts. Bubble mania is often driven by the illusion that the investment is a sure-fire winner. With housing, people sometimes bid extraordinary amounts for houses based on the belief that housing values “never decline.” As a result, some people who lost money on housing may feel so badly burned by the experience that they will be reluctant to buy another house for many years. There is also some financial logic to a reassessment of whether home ownership makes sense. Some people have found that owning a house may not be the cheapest, or easiest, way to cover their shelter needs. Thus, since the implosion, many people have moved back to renting.

When existing-home markets are weak, however, that shift from ownership to renting may take an extended period of time. Eventually, the psychology will turn, and people will become more enthusiastic about owning houses; but until people become convinced home prices offer at least some potential for appreciation, the overall demand for housing may remain suppressed.

Demographic transitions are probably also holding down the demand for the large single-family homes that we often consider the mainstay of residential real estate. Individual homes are particularly attractive as people raise their families. In the years before and after children are in the home, most people are more likely to prefer multi-family units and other smaller dwellings. In the United States we have reached the point where the “Baby Boom” generation wants to sell the large homes they owned as their families grew. But the baby boom was followed by a “baby bust,” so the immediately succeeding generation provides relatively weak demand for the vast number of homes boomers own. Thus, while there may be a growing demand for “downsized” housing, the demand for the typical “family” housing may currently be suffering a demographic lull.

Eventually, the “Echo Boom,” which tends to be the children of the Boom generation, should provide a much larger number of buyers for traditional family homes. Up to this point, however, several factors have kept those successor owners from buying. First, members of the Echo Boom seem to prefer more frequent changes than some previous generations. This cohort seems more likely to move frequently, which makes commitments to home ownership more costly. Once these individuals start families, they may begin to settle into living accommodations for longer periods of time, but until they settle down the math on home ownership tends to be unfavorable. In addition, this age cohort has also had more trouble than some previous generations getting established. It has been harder to find jobs in the last few years, and members of the Echo Boom often left school with sizeable student loans. Those factors have made it harder for potential buyers to qualify for the loans they need to purchase a house. Eventually, this age group will become established in their careers and will have the financial strength to qualify for home loans; but until that happens, the demand for single-family homes may be lackluster.

Bear in mind that enthusiasm for buying will be greater when inflation drives prices sharply higher. Thus, the relatively low levels of inflation we have experienced in the last few years have not been especially positive for home ownership. Over the long term, ownership provides a hedge against the sharply escalating price of one of the largest expenses for most households. If inflation rises in the future, buying enthusiasm should increase as the inflationary advantage of ownership becomes more salient.

While real estate activity could remain sluggish for a number of years, the demand for housing will almost certainly build over time. Already, some high-growth areas, such as Seattle and the surrounding cities, are seeing improved demand for real estate. In time, that improved demand will spread to other areas of the country. Unlike many other developed countries of the world, population growth in the United States will generate a need for more houses. The Echo Boomers represent a major source of demand that other countries simply do not enjoy. And the attractiveness of life in the United States makes immigration another source of demand for houses here. Eventually, higher inflation should make people more willing to buy a home in an effort to lock down some housing costs.

Admittedly, the last few years have been frustrating for those who bought homes at the peak of the housing bubble. Yet many of the dynamics that made home ownership attractive over the last several decades should again send prices higher in the future. While it may take longer to rebuild robust real estate activity than many expected, in time the housing markets should complete the healing process.

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This material is presented for informational purposes only and should not be construed as individual tax or financial advice. KeyBank does not provide legal advice. KeyBank is Member FDIC. Key Corp. 2014.